A quarterly magazine of the IMF

June 2001, Volume 38, Number 2

On January 25, 2001, Alan Greenspan, the Chairman of the Board of Governors of the U.S. Federal Reserve System, ended his long-standing opposition to tax cuts—opposition that had been the hallmark of President Bill Clinton's administration and the Democratic Party. With the new Republican administration of George W. Bush already heavily committed to tax cuts, and government budgetary surpluses projected to rise into the indefinite future, a strong consensus in favor of sweeping tax cuts suddenly became politically irresistible.

Undoubtedly, the sharp decline of GNP growth and the stock market in the United States during the last quarter of 2000 had something to do with Greenspan's change of heart. And the risk of a sharp cyclical downturn in the near term warrants a short-term Keynesian fiscal response—such as a tax cut—to complement the Fed's further easing of monetary policy. However, fiscal policy should be aimed primarily at facilitating longer-term structural adjustment.

Once various taxes are cut and the corresponding tax codes rewritten, these actions will be hard to reverse. Although the timing of tax cuts in 2001 may seem fortuitous for stimulating domestic spending over the next year or two, any cuts should be crafted with an eye to the more distant future. And the principal longer-term structural problem facing the U.S. economy is insufficient national savings: net personal saving by households is close to zero.

Over the past decade, personal saving has decreased more than government saving (as manifested in budget surpluses) has increased. The huge deficit in the current account of the U.S. balance of payments, about 4.5 percent of GNP in 2000, reflects this saving gap. To support a normal level of domestic investment—historically about 17 percent of GNP—the United States has had to draw heavily on the savings of the rest of the world. The "wrong" kind of tax cuts—cuts that reduce government saving but fail to stimulate private saving—could worsen this foreign indebtedness.

International dollar standard

For more than 20 years, the United States has drawn heavily on the world's limited pool of savings to support high consumption—in the 1980s by the federal government, in the 1990s by households. The United States now attracts more net capital inflows than all the developing countries combined. It has thus gone from being a net creditor to the rest of the world at the beginning of the 1980s to being the largest net debtor in the world—to the tune of $2,300 billion by 2000. The cumulative effect of private foreign borrowing over the past ten years is reflected in the balance sheets of U.S. households and firms. The indebtedness of the personal sector is now a record 1.1 times disposable income; the indebtedness of firms is also very high relative to cash flow.

Should Americans worry? After all, the dollar remains strong and the United States is unique in having a virtually unlimited line of credit, largely denominated in dollars, from the rest of the world. Consequently, U.S. banks and other financial institutions are relatively immune to currency risk; both their assets, which consist largely of domestic loans, and their (deposit) liabilities, of which a substantial fraction is owed to foreign investors, are dollar denominated. In contrast, other debtor countries must live with currency mismatches: their banks' and other corporate international liabilities are denominated in dollars, their assets in domestic currency. Indeed, this mismatch was the genesis of the Asian currency crisis of 1997-98.

Does the United States' invulnerability to currency crises simply reflect the greater strength of U.S. capital markets and the wisdom of the U.S. regulatory authorities? No. The fact that the United States is the preferred international borrower is pure serendipity. How did this accident of history come about?

In the immediate aftermath of World War II, confidence in the currencies and financial systems of all the other industrial countries had evaporated. To prevent capital flight, Japan and countries in Europe imposed tight foreign exchange controls. The relatively stable U.S. dollar was the only major currency in which international exchange could freely take place. In the late 1940s, under the newly established Bretton Woods monetary order, other nations declared official exchange rate parities against the dollar. Rather than creating asymmetry among currencies, this official monetary order simply recognized it. Thus was the dollar enthroned as the international currency of choice.

When the system of official exchange rate parities broke down in 1971, the dollar was not dethroned. To the present day, the dollar is still the vehicle currency in the interbank spot and forward exchange markets, the currency of invoice for trade in primary commodities and many industrial goods and services, and the main denomination for international capital flows. Outside Europe, governments use the dollar as their prime intervention currency—often unofficially pegging their currencies to the dollar—and U.S. treasury bonds are widely held by foreign central banks and treasuries as official exchange reserves.

The provision of international money is a natural monopoly. Once the dollar had been settled on as the central currency in the world financial system, its continued use offered huge economies of scale. The more countries A and B use the dollar in international exchange, the more attractive (cost reducing) it is for C and D to do so. The dollar can now be deposed only by some cataclysmic event—such as massive inflation in the United States. (The major exception to the dollar's hegemony as an international currency is the euro, which plays a strong role in countries on the fringe of the European Union.)

Although the dollar's central monetary role is all well and good for promoting efficient international exchange, an incidental consequence is that the international borrowing of the United States is not subject to hard budget constraints. As the rest of the world's income grows, the demand by foreign enterprises and governments for U.S. dollars to build up their international liquidity rises commensurately. The United States can provide these liquid dollar assets—whether liquid claims on U.S. banks, hand-to-hand currency, U.S. treasury or government agency bonds, or private stocks and bonds—with no well-defined time frame for net repayment. The closest analogy would be a central bank that issues fiat money within its own national monetary domain. Although banknotes and coins may formally be the liabilities of the central bank, in practice they never have to be redeemed because of the private sector's ongoing demand for domestic money.

The United States has chosen to exploit this soft borrowing constraint by absorbing capital on a net basis from the rest of the world. But an efficient dollar standard need not depend on America's running current account deficits to provide international liquidity. Even without such deficits, the rest of the world could still have dollar liquidity.

In fact, in the 1950s and 1960s, the United States ran large current account surpluses. However, long-term capital outflows—including illiquid direct investment abroad as well as development aid—were greater than the current account surpluses. This payments gap was covered by more liquid, generally shorter-term capital inflows: foreign firms built up their liquid stocks of U.S. bank deposits and money market instruments, and foreign governments built up their stocks of U.S. treasury bonds. Like a giant international financial intermediary, the United States lent long to, and borrowed short (and less) from, the rest of the world, thus satisfying the growing demand for dollar liquidity while remaining a net creditor.

In the new millennium, if the United States were to balance its current account or even to run surpluses, the rest of the world could still get the liquidity it needed. But if we accept the hypothesis that the United States' line of credit from the rest of the world is indefinitely long, why not just keep borrowing to cover current account deficits? Wouldn't U.S. consumers be better off if they continued to borrow indefinitely to keep their expenditures above their incomes?

There are two big problems with the United States' continuing to run large current account deficits: (1) U.S. households and some firms will find their creditworthiness declining as they take on excessive debt; and (2) protectionism will grow as the large U.S. trade deficit continues to erode the country's industrial base.

Financial fragility

The U.S. corporate sector is less vulnerable than households to the overleveraging that is due to the soft borrowing constraint in international markets. Foreigners can and do buy equity claims on U.S. corporations as well as industrial bonds and commercial bills. Thus, the debt-to-equity ratios of most U.S. companies, while still uncomfortably high, do not necessarily rise as a result of foreign capital inflows.

However, nobody can buy equity in U.S. households. Thus, insofar as the influx of foreign capital softens household budget constraints, it takes the form of greater household indebtedness. Although U.S. households don't seem to be borrowing from abroad, they do so indirectly through the intermediation of domestic banks and finance companies. The latter can easily and cheaply finance the proliferation of domestic consumer credit cards and mortgage lending by selling, directly or indirectly, liquid dollar deposits and other financial instruments to foreign investors. The resulting indebtedness and low net worth of U.S. households with moderate incomes make the macroeconomy less stable. For example, household indebtedness could aggravate the cyclical downturn in 2001 if it triggers a sharp rise in household bankruptcies—and a sharp decline in consumer spending.

Resurgent protectionism?

There is also a political-economic restraint on U.S. trade deficits: foreign savings can be transferred to the United States only through large U.S. current account deficits—that is, by allowing expenditures to rise above income. For any given level of income, this means a decrease in U.S. exports (broadly defined) and an increase in imports. Because, in many countries, there is heavy state intervention and protectionism in the agriculture sector and some service sectors, the industrial sector typically bears the brunt of adjustment to swings in the trade balance.

To accommodate the trade deficit, other things remaining equal, U.S. manufacturing industries must cut back production of both exports and import substitutes. Indeed, the United States has exited, or is exiting, certain industries—such as photographic equipment based on digital technologies. Where the United States has a technological lead in computers, integrated circuits, and internet-related equipment, U.S. firms will farm more of their production out to overseas affiliates because of the need for net transfers of capital from the rest of the world.

A purist might say, "If this is what the market dictates, then so be it." But, in some sense, "the market" is biased by international monetary considerations. More important, the political obstacles to preserving free trade increase when the trade deficit is large. First, when the U.S. export sector shrinks, so does the number of lobbyists in favor of keeping foreign markets open reciprocally with the domestic one. The second political obstacle is the perception, correct or not, that a large trade deficit reflects "unfair" trading practices by other countries—and that the U.S. government needs to protect domestic industry.

During the "Goldilocks" period of rapid economic growth and unusually low unemployment in the U.S. economy from 1995 through 2000, protectionist pressures were muted. However, once the economy slips into a cyclical downturn with rising unemployment and widespread industrial bankruptcies, protectionist pressures will reappear with a vengeance. In the longer run, it would be much easier to preserve free world trade if the United States balanced its trade accounts.

Disappearing U.S. treasury bonds: Should Americans worry? In announcing his support for tax cuts in 2001, Federal Reserve Chairman Alan Greenspan deemphasized the Keynesian argument usually advanced in favor of tax cuts: the need to apply a countercyclical economic stimulus to a slowing economy. Instead, taking a longer-term perspective, Greenspan worried that the large fiscal surpluses projected will eliminate the stock of U.S. treasury bonds held outside the U.S. Social Security system. Old treasury debt will be repurchased, and no new debt will be issued. The U.S. Office of Management and Budget estimated in June 2000 that debt held by the public—excluding that held in U.S. government accounts but including that held by the Federal Reserve—would be fully redeemed by the year 2012. Signs already abound that the open market for treasuries has been thinning out—with the discontinuance of new issues of 1-year bills and, possibly, 30-year bonds—and is thus becoming less liquid over time. If the fiscal surpluses continue after all treasury bonds have been retired, the U.S. government, including the Federal Reserve System, will have no choice but to use its surplus tax revenues to buy stocks and bonds issued by private sector firms. According to Greenspan, the government's granting credit to, or acquiring ownership claims on, private agents would be far too intrusive a role for the government to play in the domestic capital markets. However, if tax cuts were designed mainly to stimulate more private saving through, say, individual retirement saving plans, such as 401K plans, the net worth of U.S. households would rise. With a reduction of household debt, the macroeconomy would be less vulnerable. In principle, households might demand more treasuries with their increased saving. However, the demand for a safe, "neutral" liquid asset from important financial institutions—the Federal Reserve itself, commercial banks, insurance companies, and their counterparts abroad—would almost surely dominate bidding for the extant stock of treasuries (much as it does now). With saving-inducing tax cuts, therefore, the Greenspan "problem" of overly intrusive government in the private financial markets would be solved without increasing the current account deficit. In contrast, if tax cuts go beyond incentives to increase private U.S. saving, the supply of U.S. treasuries to the world markets will certainly increase. The cost would be an increase in the U.S. current account deficit without any improvement in the precarious financial state of U.S. households. And the share of outstanding treasuries held by foreign investors would surely rise. In the absence of any U.S. tax cuts (or expenditure increases), can the world dollar standard survive the elimination of U.S. treasury bonds from international markets? In 2000, foreign investors held about 42 percent of U.S. treasuries not held by U.S. government trust funds or by the Federal Reserve, and about half of these foreign holdings were by official institutions such as central banks or treasuries. Some countries have huge foreign exchange reserves: Japan's official reserves amount to more than $300 billion, China's to $150 billion, Hong Kong SAR's to $100 billion, Korea's to $100 billion, and Taiwan Province of China's to $100 billion. Most of these exchange reserves are in dollar assets, a high proportion of which are U.S. treasuries. Because the U.S. government owns the dollar-creating central bank (the Federal Reserve), U.S. treasuries are seen as the "risk-free asset" in the world's capital markets. The U.S. government can always create the means of settlement of its own debt—whether the debt is held domestically or by foreign investors. Under the world dollar standard, no other country can similarly create international money at will. Undoubtedly, the attractiveness of U.S. treasuries as assets has contributed to the very elastic line of credit from the rest of the world that the United States has exploited for the past twenty years. But the existence of such a safe reserve asset, with assured international purchasing power, is also very convenient for other countries. With the dollar so commonly in use as a vehicle and invoice currency, finding an equally liquid replacement to serve as an international reserve asset would be difficult, but not impossible. In the absence of U.S. treasury bonds, foreign central banks and finance ministries could experiment with holding dollar assets, such as bonds or stocks, that are claims on the U.S. private sector—or on foreign issuers of dollar-denominated debt, which could be inherently more risky. In any event, credit risk in official reserve holdings would be more of a problem. And now Greenspan's dilemma would appear in a new guise. Foreign governments as well as the U.S. government would intrude on the financing of private U.S. companies!

Tax cuts the United States can afford

If today's large budget surplus were reduced by massive tax cuts without a substantial increase in U.S. personal savings, the huge U.S. current account deficit would increase.

Americans are putting far too little into, and taking far too much out of, their pension plans. This profligacy is tax driven. Tax cuts should take the form of much higher ceilings on personal tax deductions for pension saving, and older people should be allowed to accumulate savings indefinitely under their pension plans without tax penalties.

Eliminating estate and inheritance taxes would further increase the incentives for U.S. households to save—in their pension plans as well as in other vehicles—so as to be able to pass more wealth on to the next generation. People would no longer be so eager upon retirement to convert the capital in their pension funds into annuities and consume it all during their lifetimes. Instead, retirees would leave some portion of their defined pension contributions in the plans, especially given the risks associated with putting all of one's retirement capital in a fixed annuity: there is no margin for error should a retiree be hit with some unexpected expense.

Eliminating estate and inheritance taxes would also discourage wealthier individuals from "unbuckling" through huge tax-deductible gifts to philanthropic organizations—often dubious "shell" charities or foundations over which they retain considerable personal control. The U.S. Internal Revenue Service imposes strict guidelines on these foundations, forcing them to spend down much of what they receive, further discouraging saving.

Even more radical would be the introduction of a low, flat income tax with no deductions other than a generous personal exemption. Without large tax incentives for giving to religious organizations, charities, and other philanthropies, the quality of philanthropic giving would greatly improve, even if the quantity diminished. Without any tax advantages, individuals would take much more of an interest in the success or failure of the organizations to which they contributed. Although difficult to estimate, the amount of U.S. savings leaked through tax-induced donations to all manner of not-for-profit organizations seems very large.

The bottom line is that, if one takes the balance of international payments into account, tax cuts that demonstrably increase the incentives for private saving should be at the forefront of what the new administration is considering. But this is a lot to consider and perhaps too much to hope for.